In the April edition of RAFI Fundamentals, we described how the RAFI Emerging Markets Index adds value on the order of 10 percentage points a year above the return of capitalization-weighted indexes. This added value is well beyond the excess returns to be found in developed market applications. Why the disparity? Recall the key driver in the Fundamental Index concept-namely, breaking the link between price and portfolio weight. By breaking this link, a Fundamental Index portfolio can avoid the return drag created by the propensity of cap-weighted indexes to overweight the overpriced stocks and underweight the underpriced stocks. Emerging markets, with their boom-and-bust cycles, suffer massive mispricings, leading cap-weighted indexes toward large positions in overpriced stocks and much smaller positions in underpriced stocks. The result is a considerable return drag.

The drag is curable by using a non-cap-weighted index. Figure 1 compares the returns for the median emerging market mutual fund, the cap-weighted EMI return, and the RAFI Emerging Markets Index return for a trailing seven years and more recent three-year stretch that fell after the publication of the Fundamental Index concept (to limit the backtest bias).[3] The results are striking: The RAFI index dominates both active managers and the cap-weighted index.

Half-off sales at the mall are greeted with glee by cost-conscious shoppers. The truly magnificent sales-those offering high-quality merchandise at bargain basement prices-often produce lines stretching around the block. But in the capital markets, clearance prices are greeted by many with disdain. There may be lines from around the capital-market block, but they are to sell, not to buy! The savvy investor, however, takes a long-term view and gathers bargains, such as today's emerging market stocks, and inserts them into a well-diversified portfolio consistent with the investor's time horizon and risk tolerance. Nevertheless, the investor would do well to check the label on the resulting emerging market equity portfolio. We believe those powered by the RAFI concept will maximize this unique opportunity.

Endnotes

1. We apologize for referencing different emerging markets indexes. We selected the MSCI because of its longer track record for performance purposes but have used the FTSE All-World Emerging Index for asset-class characteristics because of the availability of recent data for it. Both indexes adequately represent the opportunity set.
2. Source: eVestment Alliance
3. Arnott, Robert D., Jason Hsu, and Philip Moore, (2005), "Fundamental Indexation," Financial Analysts Journal, vol. 61, no. 2, March/April: 83-99.

© Research Affiliates^®, LLC 2008. The material contained in this newsletter is for information purposes only. This material is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument, nor is it advice or a recommendation to enter into any securities transaction. The information contained herein should not be construed as financial or investment advice on any subject matter. Neither Robert D. Arnott nor Research Affiliates and its related entities warrants the accuracy of the information provided herein, either expressed or implied, for any particular purpose. Nothing contained in this newsletter is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this newsletter should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.

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